‘Real’ assets draw mixed feeling in the wake of the pandemic. On the one hand, they have a reputation as a good place to be invested in an inflationary environment – and many economists see rising prices as a major risk today. On the other, investors appear increasingly concerned about the diminishing liquidity premium and what that means for returns.
Real assets have found favour among investors in recent years as a replacement for low-yielding fixed income or as a source of growth. Part of their appeal has been the illiquidity premium, which has provided a compelling incremental source of return. Brown Advisory puts the typical ‘illiquidity premium’ for assets such as private equity, private real estate and private credit at between 1.5% and 3% per year over public-market counterparts.
More money in the system
The problem is that the illiquidity premium has been dropping. Partly, this is simply because there is more liquidity around: private markets today are larger, have more participants and are more competitive today than in the past. At the same time loose monetary policy and fiscal stimulus have consciously pushed more money into the system. More recently, real assets have taken time to revalue in the wake of a crisis. As such, the illiquidity premium can look low relative to public markets.
However, some have also suggested that it is the weight of money moving towards these assets that is pushing returns lower. A number of pension fund managers have complained that the illiquidity premium no longer exists and private assets look less appealing. Questions have also been raised about the $900bn private debt market, where looser lending standards prior to the pandemic could catch up with returns as the fall-out continues.
Diminished but still there
For investors looking at private assets today, these difficulties need to be set against the view that private assets have traditionally offered good protection against inflation and would therefore seem to suit an improving economic climate. A number of multi-managers, including Caspar Rock, chief investment officer of Cazenove Capital, continue to see value in the sector.
As Rock says: “The premium return for investing in private markets over public markets has diminished over time, but we believe it still exists.”
However, investors need to be selective. Not all real assets will continue to perform in an environment of higher long-term bond yields and higher inflation. In a recent paper, JP Morgan Asset Management said: “Core real assets can provide effective inflation protection because about 80% or more of their returns are driven by income rather than capital appreciation. As income is generally linked to inflation, the overall return from real assets therefore also has a significant link to inflation.”
As such, private assets that throw off an inflation-linked income are likely to be more resilient, while others may come under pressure.
Data and decarbonisation
Even within individual asset classes, there are important nuances. Maria Skramic, senior associate at Brookfield, expects the positive fund-raising trend in infrastructure to continue as investors allocate more towards alternative assets, given the squeeze in the bond market and high prices in equities. However, she says some sectors have a far stronger structural growth story, highlighting decarbonisation and data connectivity as two ‘mega-trends’ in the sector.
The need for data storage has significantly increased over the past 12 months as companies and individuals have moved to cloud storage and huge investment has been required to keep pace: “We are in a 100-year upgrade cycle. Data is becoming a pure play investable asset class,” says Skramic. Decarbonisation sees similar tailwinds: “The European commission presented a plan to reduce carbon emissions by 55% by 2030, which would require Europe to double its renewables penetration. It’s estimated there is a €470bn investment gap per annum. Asia and Latin America are even further behind.”
This is creating huge opportunities.
This is in notable contrast with conventional commercial property. While low interest rates and the ecommerce trend are keeping demand high in areas such as logistics, other areas are under real pressure.
Graham Porter, head of UK investment research – real estate, at Aberdeen Standard Investments, says: “It has been a new and unforeseen change for the office market…by the time we can go back into the office, many will be reluctant to go back in full. Many in the industry are in denial about what this might mean for supply and demand.”
Not a panacea
Private equity and private debt can draw similarly mixed assessments, with some seeing continued growth against a background of strong demand, while others believe valuations have been pushed too high by investor enthusiasm. They may also be vulnerable to a changing inflationary environment.
Against such a mixed backdrop, Peter Shepard, head of fixed income, multi-asset class and private asset research at MSCI, reports that investors are increasingly taking a more nuanced approach to real assets: “Increasingly they’re shifting into a more factor-based asset allocation framework where they say, how much overall growth sensitivity do we want? Or maybe how much generalised equity exposure do we want? And then let’s figure out how much of that is coming from public equity versus private equity.”
Real assets are not a panacea. There are areas within the real assets umbrella that appear to be under structural pressure, where returns are likely to fall given the sheer weight of money pushed towards them. However, there are some that could be an important alternative to fixed income at a time when it still looks unappealing. Without high illiquidity premia to protect them, investors may need to tread carefully.